The Dodd-Frank Could be an Alternative

Mitt Romney raised the issue at the first presidential debate, contending that Dodd-Frankshould be repealed and

replaced because “it designates a number of banks as too big to fail, and they’re effectively guaranteed
by the federal government. This is the biggest kiss that’s been given to — to New York banks I’ve ever seen.”

It’s a seductive idea. Dodd-Frank contains provisions that go much further than regulating banks in order to prevent another financial crisis.

In Section 1,502, to take one example, is a provision requiring public companies to disclose whether they use conflict minerals. What this has to do with the financial crisis is beyond me. So, some parts of Dodd-Frank
may already need renovation or even repeal.

But the core of the law dealing with the big banks is another story. Simply repealing Dodd-Frank wholesale will turn back the financial clock to 2006 for these banks. That doesn’t seem very smart given what happened,
something that Mr. Romney recognizes when he talks of replacing the act rather than repealing it.

The problem is that possible replacements are unlikely to work or to be politically feasible.

The fundamental issue is that a few banks have grown to be enormous over the last two decades. According to SNL Financial, four banks each had more than a trillion dollars in assets at the beginning of the year.JPMorgan Chase was the largest with $2.3 trillion in assets, while Bank of America had about $2.2 trillion in assets and Citigroup, $1.9 trillion. Goldman Sachs is fourth with about $950 billion in assets.

That’s a lot of money, but not only are the banks big, their share of the market has grown. In the 1980s, the 10 largest banks had less than 30 percent of bank depositary assets. By 2012, this amount had almost
doubled to 54 percent.

And size has paid off for these select banking giants. They enjoy a subsidy of reduced borrowing costs because investors believe the government will bail them out if things go awry. The size of the subsidy is debated
heatedly by economists, but one recent study estimates that before the financial crisis, the banking behemoths obtained a subsidy that made their financing cheaper by 45 basis points, 0.45 percent. And at least one
study has found that banks overpaid in the years leading up to the financial crisis to acquire competitors in order to get bigger and gain this advantage.

So, Dodd-Frank didn’t create “too big to fail” institutions. The banks themselves did because it made them money.

The financial reform law takes two tacks in dealing with these institutions. First, Dodd-Frank tries to figure out who they are and charge them for being too big. This is done by raising their regulatory costs through more
oversight and supervision.

It means more governmental red tape for these banks, but also ostensibly fewer problems because of it. Regardless, one purpose of this increased regulation is to impose a regulatory tax on big banks to push them to
be smaller.

Second, Dodd-Frank addresses the “Lehman” problem — that bankruptcy may not work for a huge financial failure. Instead, a new regime is created to put big institutions into what is hoped to be an orderly
receivership that avoids a general financial panic, something that unfortunately happened when Lehman Brothers filed for bankruptcy in September 2008.

Repealing Dodd-Frank will not make these banks go poof and disappear. Instead the banks, which have only grown larger and more concentrated since the financial crisis, will continue to enjoy a subsidy. After all,
when push comes to shove, no president will simply let a $2 trillion institution go down. It would destroy the economy.

The real question then is whether there are any alternatives to Dodd-Frank other than repealing it.

The two options that are most often discussed are to break up the banks or impose a capital charge.

A breakup is the favorite choice of many and has even been mooted by Sanford I. Weill in July, a number of years after he left Citigroup, the behemoth he created. Daniel K. Tarullo, a Federal Reserve governor, recently
proposed a simple suggestion: capping the size of a bank’s balance sheet. But in a large financial system, you need large banks as lenders.

Even if you can function without large banks, the political feasibility of a bank breakup in a Democratic administration, let alone Republican one, is unlikely.

Luigi Zingales writes in his provocative book “A Capitalism for the People” (Basic Books) that the Glass-Steagall Act, the Depression-era law that separated investment banking from commercial banking, was good
because it led to competition among banks rather than allowing them to bond together to fight for their bigness.

In other words, the big banks would now resist such a solution to the death. (Mr. Zingales, by the way, is a member of the University of Chicago faculty and has been a co-author with Glenn Hubbard, a central Romney
economic adviser.) Like it or not, we are probably stuck with large banks. And there will always be smaller institutions that are simply too interconnected to be allowed to fail.

This leaves the second option and probably the one that Mr. Romney is likely to favor: higher capital requirements or leverage limitations for the biggest banks. This may work but essentially does the same thing that
Dodd-Frank claims to do — make it more costly to be a “too big to fail” bank.

This solution has the virtue of being easier to administer and certainly requires less regulatory power. But the solution would leave a future administration gasping if one of these banks went down.

And the capital charges would have to be agreed on internationally in order to keep American banks from being outgunned by foreign competitors. This is what the Basel III accords are supposed to do, but raising the
capital or leverage limits would require a whole new international bargain.

This is unlikely to happen anytime soon because the European banks lack the wherewithal right now to raise their capital even if they wanted to. Even more problematic is that raising capital and leverage requirements
may reduce lending more than the current regulatory provisions do because banks would be forced to keep more money on their books rather than lend it.

The bottom line is that there are real problems with Dodd-Frank. It contains tons of extraneous stuff, and even the provisions dealing with the large banks are sometimes too convoluted and intricate. The mess that the
regulatory agencies are in as they try to sort out the Volcker Rule is a good example.

But while it is nice to talk of repealing or watering down Dodd-Frank, the alternatives may not be much better as long as we have big banks. And those don’t seem to be going away any time soon.